And Another Thing…

Following last week’s column I am obviously in the bad books of a small number of buy side firms and as such I intend, in true fashion, to dig myself in a little deeper today. There is a trend in the buy side, indeed business generally, that makes peer-to-peer matching on any reasonable scale even more impossible than I argued last week.

The problem is scale, or rather, too much of it.

Consolidation, often through mergers and acquisitions, seems to be the only way people can think – organic growth is so passé apparently! The problem is, for the buy side, this raises serious operational issues that will threaten their underlying performance. I am thinking specifically of the asset management community, members of which seem quite keen to disintermediate the banks.

Forget the fact that merging technology infrastructures is, and will continue to be, a nightmare – or even that many roles will be duplicated until such time as cuts are made. Focus instead on the basic aspect of actually getting into and, more importantly, out of, positions – here there is a lesson from the hedge fund world that they would do well to heed.

There is a real manoeuvrability issue when it comes to trading the markets in which they invest and, looking at FX, hedge. A good number of global macro hedge funds suffered a lean spell not only because of reduced opportunities in markets, but also because their business was getting large enough to be unprofitable for the banks or LPs – even if they did execute over a period of time. The problem was exacerbated when it came to getting out of their positions – turning a position measured in the yards meant serious slippage and, because these firms had turned to third party solutions, the biggest source of liquidity out there – the banks – were less inclined to help out; especially once the banking industry realised the “flow at any cost” strategy was a bust.

These massive hedge funds were simply too big to operate efficiently in markets and they needed to make outsized returns (which many did of course) to make up for execution slippage. That’s just about OK in a world with plenty of opportunity, but in the current environment? Where low percentage returns are available in most markets and cash earns you nothing? That’s a tough environment in which to be successful.

So roll this into the asset manager world, where firms are getting bigger and bigger. The recently mooted UBS Wealth Management-Deutsche Asset Management link up would create a firm with $1.5 trillion of assets under management. The fees would be good of course, but how easy would it be – even with thousands of funds and portfolio managers – to get into and more importantly, out of, positions? Shifting one per cent would be a challenge and it is investors who would pay the price of course.

If you wanted to exacerbate the situation then how could you do it? Well you could start by disintermediating your LPs of course – although there is no guarantee that will do it, which is something that bothers me as an old spot trader.

I would be afraid that my institution would still seek to let these firms cherry pick my liquidity and that they wouldn’t have the courage to stand up and say no to them when they come calling when their wonderful little private room has (understatement alert!) skewed order book.

The whole idea of growing in size at the same time as you disintermediate a key group of service providers seems silly to me, but this is, in certain instances, what appears to be happening. All I can say, is what I said last week – good luck with that!